Quantitative easing and unconventional monetary policy

David Miles interviewed by Viv Davies, 27 Nov 2012

David Miles talks to Viv Davies about the conclusions of his recent research on quantitative easing and unconventional monetary policy. Miles discusses the different types of 'asset purchasing programmes' adopted by the Bank of England, the Fed and the ECB; they also discuss the importance of current research in these areas and the potential risks associated with quantitative easing. The interview was recorded at the Bank of England on 21 November 2012. [Also read the transcript]

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Viv Davies: Hello and welcome to Vox Talks, a series of audio interviews with leading economists from around the world. I’m Viv Davies from the Centre for Economic Policy Research, it’s 21 November 2012 and I’m speaking with Professor David Miles, member of the Bank of England’s Monetary Policy Committee. We discuss Professor Miles’ recent research on quantitative easing and unconventional monetary policy. I began the interview by asking David to provide us with a brief summary of the paper and its conclusions.

David Miles: It’s a paper that really tried to step back and look at some of the recent empirical and theoretical literature on what the impact of quantitative easing might be, and try to see where we stand. I think that the main conclusion of the paper was that if one looks at the now quite large literature on what the impact of large-scale asset purchases is, I think there is a consensus emerging that those asset purchases by the Bank of England – the Fed in the US has done things on a similar scale – have had a positive on economies. They brought down a range of interest rates and had a positive impact on demand.

Different studies will give you different numbers for quite how powerful they are; the studies I’m most familiar with are those which look at the impact of purchases by the Bank of England. I think the average estimate would put the impact of the large-scale asset purchases done here in the UK at maybe the equivalent of boosting GDP by as much as a couple of per cent, and being the equivalent in terms of its impact of a very large cut in short-term nominal interest rates. Obviously those policies were embarked on by the Fed and the Bank of England, and also the ECB in its own way, once the interest rates had reached their lower bound, but you can nonetheless ask the question: what equivalent impact of cutting interest rates in ordinary times have asset purchases had? And the answer that most studies have come up with is that they’ve had an impact which is equivalent to a very large reduction in short-term interest rates, many percentage points.

VD: So it seems that there are a number of different types on quantitative easing or asset-purchasing programmes. Could you give us some insight in to what these are and why and how these programmes differ between central banks?

DM: One way in which they differ is in the nature of the assets that are purchased. Here in the UK, the Bank of England has overwhelmingly bought government bonds. In the US it’s been a mix of the Fed buying government debt but also buying securities. So one way to distinguish between different forms of asset purchases is whether the assets bought are issued by the private sector or by governments. In some ways the differences between what asset purchases happened in the US and the UK is not quite as great as appears at first sight, because nearly all the assets bought, nearly all the mortgage-backed securities bought by the Fed are actually insured one way or the other by quasi-government agencies. So they’re not quite pure private-sector assets.

The ECB has embarked on a slightly different strategy: its outright asset purchases are limited relative to the scale of asset purchases by the Fed and by the Bank of England, but they have nonetheless undertaken an enormous increase in the balance sheet, largely through so-called ‘repos’, that is long-term loans made directly to the banking sector in exchange for collateral. So they’re not asset purchases, but they have an impact which is in some ways comparable to asset purchases. You could think of a repo transaction, a long-term repo, as a decision by the central bank to buy some assets off the banking sector, but agree in advance the date and price at which you would resell them later. That’s a bit different from what the Fed and the Bank of England have done, where we’ve bought assets outright without a fixed date and certainly no fixed price at which we would resell them.

VD: Your paper was one of a number of papers on unconventional monetary policy that were published recently in a special edition of the Royal Economic Society’s Economic Journal. How important would you say the contribution of the research community is to developing our understanding of the mechanisms and impact of QE-type programmes?

DM: I think it’s very important. I know from my own experience here at the Bank of England, when we meet as a monetary policy committee each month, we have been updating and reassessing the evidence on the impact of asset purchases. In many ways it was a step in to the unknown for us in the Bank of England, and the same would be true for the ECB and the Fed, because we hadn’t undertaken asset purchases on this scale in recent history. There was a significant degree of uncertainty at the outset of quite how powerful a tool this was, and so the evidence that’s been amassed in the last three or four years on the impact of this has been something that here in the Bank of England we’ve been monitoring very closely. It’s been helpful for us on the Monetary Policy Committee in working out quite what the right scale of asset purchases should be.

VD: Is there a deeper existing literature on this, or has the current research been born out of the severity of the financial crisis?

DM: I think the scale of asset purchases we’ve seen from central banks in the last few years is unusual, and there are very few historical episodes to draw upon for assessing what impact those asset purchases might have. There is a large, perhaps theoretical literature on what the impact of changes in central banks’ balance sheets might be. Some of that literature gives you very clear-cut answers, but at the expense of making a set of assumptions that are not really applicable in the current environment. So for example there’s an extremely clear and interesting paper written seven or eight years ago by Michael Woodford and Eggertsson which shows that large-scale asset purchases by a central bank, either of government bonds or indeed of other assets, under certain conditions has no impact whatsoever. That’s an absolutely watertight theoretical result, but it only holds under extreme assumptions that the private sector can, in a sense, unwind the actions of a central bank by operating in perfectly efficient financial markets.

It’s a useful theoretical benchmark, but I think even under ordinary circumstances it’s of rather limited relevance. Certainly in the circumstances of the last three or four years, in the aftermath of a major financial crisis, the assumption that financial markets are operating efficiently and people are lending and borrowing freely in the private sector is an assumption that’s so far off the mark that that theoretical result is of very limited practical relevance. Though I think the very recent literature on the impact of asset purchases has been crucial for central banks assessing what the scale of the operation should be.

VD: So clearly there are risks associated with QE, not least the potential threat of uncontrollable inflation. What do you see as the main risks to QE, and how confident are you that those risks can be mitigated?

DM: The risk that large-scale asset purchases will generate very substantially higher rates of inflation is a risk that’s often overemphasised, I believe. The reason I think it’s overemphasised is that the reason why central banks and the reason why the Bank of England embarked on asset purchasing was precisely to try and hit an inflation target in an environment where the economic downturn was so severe that it looked likely that, without a more expansionary monetary policy, ultimately inflation might be driven beneath the target level and sit beneath it. Just as it was with an eye to longer-term inflation pressures that the Bank of England – and the same is true for the Fed – undertook the asset purchases, it will be the underlying inflation pressures in the future that will determine the rate at which the asset purchases are unwound or reversed. I don’t see any great technical difficulty in reversing quantitative easing.

When the time comes at the Bank of England we’ll sell the assets in much the same way as we bought them: by holding regular auctions. The only difference will be that instead of auctions in which the bank is buying assets they’ll be more conventional ones in the sense that we’ll be trying to sell something which is the gilts. The timing of the asset sales and the rate of asset sales will depend very much on the inflation outlook. I certainly don’t believe for one moment that the fact that the asset purchases were financed by the creation of money, bank reserves, that inevitably must mean that ultimately we will generate inflation. I think that ignores the fact that those transactions can and indeed will be reversed.

VD: Finally, David, how far do you think we can go with quantitative easing before there’s a danger that it morphs in to fiscal policy by another name? Is there a sense now that the boundaries are becoming rather blurred?

DM: I don’t think they are blurred, and it really is because the decision to undertake asset purchases has been made with a view to the broader economic environment and, in particular, the inflation pressures. Because the outlook for inflation was the main determinant for the scale of asset purchases, provided that remains the case I think that really makes the risk of what you may call permanent money financing by the central bank, and undermining of its independence, and a mixing of fiscal and monetary policy, the risk that that happens and that it inevitably means that inflation will end up being considerably higher is not a very substantial one. What’s crucial is that the central bank has in mind, as the main driver of its decision about asset purchases, what the underlying inflation pressures in the economy are.

In terms of the other aspect of your question – are we getting close to the feasible limits of quantitative easing – here in the UK it remains the case that the stock of outstanding government bonds that are available in principle for the Bank of England to buy, remains extremely large even after the Bank of England having bought £375bn of gilts. The stock of outstanding bonds available to buy is larger now than it was when we embarked on asset purchases back in 2009. That’s because the government has issued substantial new debt in the intervening period.

VD: David Miles, thanks very much for taking the time to talk to us today.

Topics: Monetary policy
Tags: Bank of England, ECB, Federal Reserve, quantitative easing, unconventional monetary policy

Banking union: Ireland vs Nevada, an illustration of the importance of an integrated banking system

Daniel Gros, 27 November 2012

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The Eurozone crisis has demonstrated how an insolvent sovereign can destroy a national banking system, Greece, but also how an insolvent banking system can almost sink the sovereign – Ireland and Spain (Wyplosz 2012).

Topics: EU institutions, EU policies
Tags: banking union, ECB, fiscal union, Ireland, Nevada

Banking union and ambiguity: Dare to go further

Sylvester Eijffinger, Rob Nijskens, 23 November 2012

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On September 12, the European Commission published a proposal to establish a banking union in the Eurozone1. This proposal delegates the supervision of large cross-border banks to the ECB. The ECB will also be responsible for supervising smaller banks, in cooperation with national supervisors.

Topics: EU institutions, EU policies
Tags: banking union, ECB, interest rates, supervision

From the internal market to a banking union: A proposal by the German Council of Economic Experts

Peter Bofinger, Claudia M. Buch, Lars P Feld, Wolfgang Franz, Christoph M Schmidt, 12 November 2012

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 The European sovereign debt crisis has revealed severe flaws in the design of the internal market. Both private and public borrowers had incentives for excessive borrowing, which have been created by deficits in the regulatory structure of financial markets. Capital requirements for banks were too low and had procyclical effects (Favara and Ratnovski 2012).

Topics: EU institutions, EU policies, Macroeconomic policy
Tags: banking union, ECB, European Stability Mechanism, eurozone

Outright Monetary Transactions sterilised?

Michael McMahon, Udara Peiris, Herakles Polemarchakis, 30 October 2012

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The Governing Council of the ECB recently announced that the Eurozone will be undertaking ‘Outright Monetary Transactions’ (OMT). This means that the ECB will be transacting directly in secondary markets for sovereign bonds of Eurozone Member States.

Topics: EU policies, Macroeconomic policy, Monetary policy
Tags: ECB, Eurozone crisis, financial crisis

The first step in Europe’s banking union is achievable, but it won’t be easy

Nicolas Véron, 29 October 2012

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The leaders of Eurozone countries issued an unprecedented commitment on 29 June; the statement began, “[w]e affirm that it is imperative to break the vicious circle between banks and sovereigns” (Euro Area Leaders 2012).

Topics: EU institutions, Europe's nations and regions
Tags: crisis management, ECB, EZ banking union

The first step in Europe’s banking union is achievable. But it won’t be easy.

, 1 January 1970

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The leaders of Eurozone countries issued an unprecedented commitment on 29 June; the statement began, “[w]e affirm that it is imperative to break the vicious circle between banks and sovereigns” (Euro Area Leaders 2012).

Topics: EU institutions, Europe's nations and regions
Tags: crisis management, ECB, EZ banking union

The Single European Market in banking in decline – ECB to the rescue? 

Daniel Gros, 16 October 2012

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The prudential rules for banks are in principle the same throughout the EU, as they are codified by various EU directives and regulations. In reality, however, these supposedly common rules are implemented by national supervisors today in such a way as to ‘balkanise’ the Eurozone’s banking markets.

Topics: EU institutions, Europe's nations and regions
Tags: ECB, EZ banking union

Banking union as a crisis-management tool

Charles Wyplosz, 16 October 2012

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There can be no banking system without a lender of last resort. Some countries have various mechanisms that provide lending in first resort when a bank fails. This can be a deposit insurance agency, a rainy day fund fed by bank dues, or an understanding that banks rescue each other when the need arises.

Topics: EU institutions, Europe's nations and regions
Tags: crisis management, ECB, EZ banking union

The path to sustainable recovery for the Eurozone

Christopher Sims interviewed by Viv Davies, 12 Oct 2012

Nobel laureate, Christopher Sims, talks to Viv Davies about the institutional restructuring needed to put the Eurozone on a path to sustainable recovery. Sims contrasts the structural differences of the US, Japan and the UK with the Eurozone; they discuss the role of the ECB, eurobonds, a common fiscal commitment, and the rationale for country-level default. They also discuss Sims' prophetic paper on "The Precarious Fiscal Foundations of EMU" (1999), in which he wrote about the risks of a euro crisis.The interview was recorded in Brussels on 21 September 2012.

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Sims, Christopher (2012), "A least unlikely path to a sustainable EMU", presentation at the EABCN workshop in Brussels, 23 September.

Sims, Christopher (1999), "The precarious fiscal foundations of EMU"

Transcript

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Viv Davies: Hello and welcome to Vox Talks, a series of audio interviews with leading economists from around the world. I’m Viv Davies from the Centre for Economic Policy Research, it’s 21 September 2012 and I’m talking with Christopher Sims, Nobel laureate and professor of economics and banking at Princeton University. We met at a meeting of the Euro Area Business Cycle Network in Brussels, where Professor Sims presented his ideas on what he referred to as a least unlikely path to a sustainable EMU. I began the interview by asking Chris to explain what he described in his presentation as being the long-term direction on institutional restructuring that would be required to put the Eurozone on the path to a sustainable recovery.

Christopher Sims: If you look at objective measures of the fiscal situation in the US and Japan, or the UK for that matter, they look worse than such objective measures for the Eurozone as a whole or even for most of the southern-tier countries. Debt to GDP ratios and deficit to GDP ratios are in dangerous territory in Japan and the US. And yet neither of those countries, and the same is true of the UK, is paying anywhere near the premium for default risk that the southern-tier European countries are paying. My view is that that reflects institutional structure that’s common across the UK, Japan and the US that’s missing in the euro area. The other three countries all have a central bank that corresponds to a single treasury. The single treasury issues nominal debt, and it answers to a legislator that’s in a national legislature. This has several consequences: one is that the lender of last resort function is much firmer in the US, the UK and Japan because the lender of last resort has to be an institution with deep pockets that can lend and itself be subject to very little or no worry about default risk. So at a time when liquidity dries up because everybody begins to feel that every counterparty might have substantial default risk, a big institution that can come in and lend to people who are unable to get credit can resolve the situation.

This has happened historically many times. It used to be that sometimes large private banks that were large on a national scale could perform this function. But even a large private bank can be subject to default risk itself, so in a big enough crisis it can’t act. But a central bank that can, if necessary, be recapitalised by a legislature that issues nominal government debt, has essentially unlimited pockets. Its debt issue involves no commitment to provide anything except paper, so nobody will have doubts about whether it’s going to default on the debt it issues. Of course if the legislature and the treasury are in a position where they might run deficits forever, then the nominal debt can become worthless. It can get inflated away.

But that’s not the situation in Europe now. Europe is not having a crisis because people think it can never run primary surpluses again; it’s having a crisis because the southern tier countries have promised to pay not paper they can issue but euros that they can’t issue on their own, and there’s a real possibility that they may not be able to raise the euros that they have promised. That’s the issue. So in going in to the euro area, the EMU countries have given up on this possibility of having a national lender of last resort that’s as effective as those in the UK, the US and Japan. And the ECB, in its original formulation, was never supposed to be a lender of last resort. But in the crisis we’ve seen, Europe, like other advanced economies, needs a sound lender of last resort. And in order for that to happen there has to be some kind of institutional mechanism that reflects political consensus that there can be such a thing as a euro area-level fiscal commitment. There has to be a recognition be financial markets that at the level of the euro there can be decisions to pay returns on assets and to issue debt that is backed by euro area commitment. So far that hasn’t happened, because there’s so much concern in the euro area about one country or group of countries being ripped off by other countries or groups of countries in any arrangement that actually involves shared fiscal commitments.

At some length, that’s what I think is the fundamental problem in the euro area, that finding ways to construct institutions that convince markets that there is such a thing as a shared fiscal commitment at the euro level.

VD: So you’d be in favour of eurobonds, then?

CS: Yes, some form of eurobonds. You don’t want to think of all countries’ debts being made into eurobonds, and I don’t think you even have to have eurobonds being most of the European area debt. Countries ought to be mostly issuing debt that’s their own obligation. They should be able to default on that debt. Default premia on country debt should be possible. But you could have eurobonds since European-level government organisations don’t have very big budgets, so the eurobonds might come through an agency that bought sovereign debt from individual countries and used eurobond issue to finance that. Of course, such an agency would be making political decisions, and it would need careful consideration of what kind of democratic backing to give such an agency. But what we have now is, in emergency after emergency, the ECB is moving closer and closer to being such an agency itself, and that necessarily weakens its independence as a central bank. It becomes involved in essentially political decisions, and the structure of that institution is not that of an agency that’s making political decisions. It’s meant to be a central bank with a narrow objective, that mainly technical problem of keeping inflation stable. It’s not meant to be making controversial judgements about which countries’ debt should be supported in value because markets have an exaggerated idea of default risk, versus which countries’ debts actually are insolvent and need to be at least partially defaulted. But that’s what it’s having to do in the current situation.

VD: So you see that a natural progression, maybe, is towards a more federal Europe?

CS: Yes, though right now the analogy with the US is certainly incomplete. US state budgets are non-trivial relative to the federal government budget, but their debts are small relative to the federal government. Whereas in Europe the central government’s budget is tiny relative to the country governments, and some of the individual countries have debts that are a substantial fraction of EU GDP, whereas that’s not really true of US states. Nonetheless, I think a movement in the direction of a federal Europe – banking union, some form of eurobonds – are the only way to provide a stable euro monetary unit.

VD: You wrote somewhat of a prophetic paper in 1999, outlining the challenges that would face the EMU. Could you give us a little of an explanation of that?

CS: That paper was called “The precarious fiscal foundations of EMU”, and it was written from the perspective of the fiscal theory of the price level, which I worked on before. Most of the models in that strand of literature had worked with single-country models, but what you thought about EMU from the perspective of these models you saw two things. One is that, so long as there’s country debt or euro debt or equivalent, and the central bank was controlling the interest rate on government debt, there would be a free-rider problem. That a single country wouldn’t directly face any consequences form issuing steadily growing debt. And in effect what would happen if it did that would be that, if the price level remained stable, it would remain stable through other countries running steady surpluses that offset the steady deficits of the free-riding countries. I argued that that wouldn’t be sustainable, that there would be a necessity for some kind of fiscal discipline or control. This was assuming that the ECB did what it essentially did, which was to treat all kinds of sovereign debt of European countries as essentially equivalent in its monetary operations. At the beginning it managed to keep interest rates constant across countries, for all practical purposes. So the debts were equivalent, you would think of the ECB as controlling the interest rate on safe securities – safe securities were euro area government debt. But if it were going to do that there would have to be some kind of fiscal backstop, and I argued that what was in the Maastricht treaty, which were penalties for countries that violated these fixed limits on deficits, the debt-to-GDP ratio, were not credible. My view was then, and still is, that the way countries get in to a situation where they are violating these limits, is something really bad happens to their economy. It didn’t seem credible that something bad would happen to one country and the other countries would then say: “Okay, you have to pay a fine.” And in fact we’ve seen that this is exactly how it worked. That there were such penalties supposedly, but that the first countries to violate the limits were not penalised, because everybody could see that they had a good excuse.

My feeling is that attempting to create fiscal discipline without punishments is not going to work. And I think that as long as everyone’s issuing debt denominated in euros, there’s a common currency. One has to admit that there is a possibility of country-level default, and that it can occur without exit from the euro. And at the beginning of the crisis, the ECB was thinking of monetary policy in the traditional way and was thinking that there is no provision for default or for exit from the euro, so it had to act on the assumption that default was impossible. And that’s part of why we’ve got to the difficulty we have. There should be a eurobond, a common fiscal commitment, and at the same time an admission that country-level default is possible.

VD: That’s a great summary. Christopher Sims, thanks very much.

Topics: Global crisis
Tags: ECB, eurobonds, Eurozone crisis

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